Why Loan to Deposit Ratio is so Important for The Approval of a Loan

Loan to Deposit Ratio = Loans ÷ Deposits

Loan to deposit ratio is utilized to determine thecapability of lenders or banking institutions to cover the withdrawing amountsby customers. The values used in the formula are exactly the same as the nametells i.e. loan and deposit.

Any lending institution accepts deposit from customers andit must have to maintain a level of liquidity to support its daily operations. Theloans to customers are basically an investment and cannot be considered as a liquidasset because it is a long-term investment.

The central bank of each country regulates all the statutory banks to maintain a certain level of reserves to maintain its daily operations. However, the approach may differ from country to country, it may require banks to maintain a certain percentage of non-lending wealth as a liquid asset (i.e. cash) to meet the needs of cash for customers for daily operations.

Loan to Deposit Ratio

How the loan to deposit ratio measures liquidity

In the equation above the loans in numerator indicates theinvestment for the banks. On the other side on can also say investments as a currentasset because they are receivables also. In the denominator, the value ofdeposits is considered as debt on the bank as individuals are giving money tobanks for a return. This money can be called back at any time, therefore,measuring management capability of a bank is important in many aspects.Moreover, the debt ratio can be helpful to use along with loan todeposit ratio to gauge things in a better way.

How the loan to deposit ratio is useful for investors

The use of ratio is not limited for internal purpose, ratherexternal use is also very common. The ratio is used to determine the financialviability of an entity in a short-term scenario. The depositors may want to knowthat if money needed any time in the future will be available or not, here theloan to deposit ratio is much helpful. Similarly, banks use debt to incomeratio when approving a loan to an individual to measuring the capability ofa person to return the loan. Insurance companies may sometime use a variationof loan to deposit ratio to calculate the insurability of a policy.